Accounting 467 CASE Fall 2016 (75 points possible)

Use the format provided on page 3 to word process your memo. The solution to this final case is the completed memo. The length is 2-3 pages single spaced, but concise and direct in your memo. The partner, Linda Smith, works with many clients so you should avoid assuming she will fully recall all relevant facts, or that she will immediately recognize all important implications of those facts. Be sure to describe the specific facts you consider relevant and explain the implications for the Freja audit engagement.

Freja, Inc. is an international retailer and designer of athletic apparel. The company, founded in 1998, makes a number of different types of athletic wear, including performance shirts, shorts, and pants, as well as lifestyle apparel and yoga accessories. They sell their clothing internationally. In 2005, the company went public to support business expansion through acquisition of other athletic apparel lines and designs. The expansion happened in two ways 1) a 2006 purchase of three patents from the original designers of a technically designed compression wear, marketed to biking enthusiasts and 2) the 2011 acquisition of Crescent Moon, a company with a high quality line of yoga apparel.

To maximize the investment in the patents, Freja built a new production facility to increase production of biking compression apparel in hopes of selling more and capturing at least 30% of the market share. The production facility is located in Cambodia and began production in 2008.

The Crescent Moon yoga apparel is produced by a Guatemala supplier. Freja has maintained the supply relationship.

A distribution facility was completed in January 2016. The facility is located in Memphis, Tennessee. The cost was $15,000,000 and the building has an estimated 40 year life. Freja uses the straight-line depreciation method.

You are the senior auditor on the team assigned to the Freja financial statement audit for the year end, December 31, 2016. It is December 29, 2016 and the interim work for the December 31, 2016 financial statement audit is completed. Your firm, RJN, acquired Freja as a client in 2002. Freja anticipated going public in 2005 and changed auditors to work with a firm that is PCAOB registered and has more experience with SEC filings. Frejas board of directors is independent of the executives of the company, except for the CEO, Marcy Madden. All of the board members own shares of Freja. The majority of the board was in place when Freja went public. Frejas audit committee of the board is meeting in 2 weeks and has asked the RJN engagement partner, Linda Smith, to explain the significant risks identified during RJNs interim audit tests and the year-end audit planning.

Smith has asked you to prepare an audit planning memorandum that addresses significant engagement issues, and specifically identifies matters relevant to the audit committee. To prepare the requested memo you have consulted last years audit file -EXHIBIT I, findings of interim audit procedures EXHIBIT 2, a memo prepared by Smith following a December 15, 2016 client meeting EXHIBIT 3 and the preliminary December 2016 unaudited balance sheet and income statement EXHIBIT 4. Freja shut down operations for the remainder of 2016 beginning December 24, 2016. The preliminary balance sheet and income statement were prepared on December 28.

REQUIREMENTS

Your task as the senior on the audit team is to prepare a memo for the engagement partner based on the Freja information provided in the case, including EXHIBITS 1, 2, 3 and 4. The planning memo should address the following: 1) Client business risks, 2) Audit risk factors, 3) Accounting issues, 4) the accounts with the most significance to the audit. Prepare the audit planning memorandum using the following format (Italicized text gives instructions for completion of the memo):

RJN, CPAs W/P Reference

Date: 12/20/2016

Client: Freja, Inc.

Period End: 12-31-2016

Purpose of the memorandum

The purpose of this memo is to document(finish the sentence(s))

Business Risks Facing Freja, Inc.

(Write an overview paragraph here)

(Bullet-point descriptions of each business risk here)

Audit Risk Factors to be Considered by RJN

(Write an overview paragraph here)

(Bullet-point descriptions of each audit risk here)

Accounting Issues Identified

(Write an overview paragraph here)

(Bullet-point descriptions of each accounting issue here)

For the bullet-point descriptions of each accounting issue, include sub-headings as follows:

Accounting Issue:

Significant Accounts due to identified client business risks, audit risks, and accounting issues:

Accounts:

Concluding Remarks

EXHIBIT 1

Observations Noted in RJNs Last Years 2015 Audit File

2015 sales increased but the gross profit rate decreased 2%. The sales growth indicates the goal of increasing market share in the biker compression apparel is being realized. The gross profit on the product line is lower than planned. Competition from Under Armour is stronger than expected.

In the last six weeks of 2015 it was discovered the reusable bags made of polypropylene Freja orders from a China supplier had high levels of lead and concerns about possible lead poisoning were being evaluated. Freja has used these bags to package all products since 2009. At the time of the discovery, $340,000 of the bags were on hand. The company halted use of the bags and was investigating possible costs of recall, destruction of inventory and any possible claims of injury as the year ended. The probability of loss and any estimate of dollar cost could not be assessed at the date of the 2015 audit report.

Accounts receivables are from the independent retailers. Business customers who market the company apparel and sports organizations or team that custom order for their athletes buy on credit terms. Individual consumers buy at Frejas retail locations or online. Those customers purchase with third party credit cards. The client is monitoring the collection of the receivables but agreed to increase the allowance for the 12/31/15 financial statements.

Freja implemented a new sales incentive plan in 2015. The sales management team earns a bonus based on increase in both sales volume and sales dollars and gross profit dollar growth. The sales bonus pool is calculated on the year end financials and paid by March 15 of the following year.

EXHIBIT 2

Findings from Interim Audit Procedures

Conducted in September and November 2016

Accounts receivable were confirmed as of November 30, 2016. The accounts receivables are related to the apparel sold to business customers and custom orders for sports organizations. The total sales through November 30 for those products were $46,000,000. The number of days to collect sales has increased from 43 days to 50 days for the accounts receivables due from these customers. The allowance for doubtful accounts aging percentages have not been increased to reflect the slower paying customers. Credit terms for the business and sports organizations customers have been revised to allow more days to pay and establish higher credit limits.

A sample of cash disbursements was tested. The controls surrounding disbursements were operating effectively. It was noted Freja is paying vendors on the average of 40 days from vendor invoice date, an increase from the average of 36 days to pay in the 2015 audit.

Inventory of all product lines has increased. The company estimates the various apparel products have market appeal for up to 10 months. Even though the products do not lose quality, the market expects changes in color and style. Freja attempts to satisfy the market with updated colors and styles every eight months. The company typically sells outdated inventory to outlet and liquidation retailers at 20% below cost. As of November 30, Freja estimates 40% of the inventory is made up of the outdated color and style apparel. Freja has not made any valuation adjustments.

A building addition depreciation expense was not calculated as of the November 30 interim date.

EXHIBIT 3

Audit Partner Memo to File

December 15, 2016 Audit Planning Meeting with Client

On April 16, Freja declared a $2,000,000 dividend, paid on May15.

Freja issued new shares of stock on December 10 and used the cash to repay a portion of the debt incurred with the Crescent Moon acquisition.

The recall of the bags in the previous year continues to be investigated. Freja has been named a defendant in three lawsuits claiming persons have health issues related to the lead content in the polypropylene bags. Freja has not assessed the likelihood of loss or estimated a dollar amount of a possible loss.

The goodwill asset was recorded with the Crescent Moon acquisition. At the time of the acquisition Crescent Moon had 55% of the yoga apparel market. As yoga has become more popular more competitors have entered the yoga apparel business. Crescent Moon has experienced a 3% sales decline in each of the last 4 years and now has 40% of the market share. The value of the overall business has decreased. The valuation of goodwill needs to be assessed.

Two of the three patents purchased in 2006 proved valuable and are the designs for two apparel lines that are profitable. The design for the third patent proved too costly to produce. Freja allocated $3,600,000 to that patent, with a life of 12 years. The client has abandoned hope of using the patent, but has not written it off as of December 2016.

The production facility in Cambodia was established to take advantage of lower cost labor. A production plant in Ohio was closed when the Cambodia plant opened. Management has concerns how that arrangement may be altered when Donald Trump assumes the U.S. presidency in January 2017. The facility has a carrying value of $13,000,000 as of 2016 year end.

EXHIBIT 4

Freja, Inc. Balance Sheet (in thousands)	2016 unaudited	2015	2014
Assets
Current Assets
Cash	200	456	1,300
Accounts Receivable	7,589	4,784	3,788
Allowance for Doubtful Accounts	(1,000)	(889)	(500)
Inventories	21,800	8,600	7,000
Prepaid Expenses	2,480	1,654	1,138
Plant and Equipment	43,000	28,000	28,000
Accumulated Depreciation	(6,450)	(5,500)	(4,700)
Patents, net of amortization	13,000	13,500	11,000
Goodwill	8,000	8,000	8,000
Other Assets	4,976	2,696	423
Total Assets	93,595	61,301	55,449
Liabilities
Current Liabilities
Line of Credit	10,600	7,800	6,500
Accounts Payable	14,500	3,420	3,300
Accrued Liabilities	5,070	2,680	3,940
Noncurrent Liabilities
Long Term Deferred Tax Liabilities	8,134	4,600	3,250
Mortgage Payable	25,000	10,000	10,000
Long Term Payable	2,000	8,000	8,000
Shareholder's Equity
Capital Stock	18,000	12,000	12,000
Retained Earnings	10,291	12,801	8,459
Total Shareholder's Equity	28,291	32,801	28,459
Total Liabilities and Shareholder's Equity	93,595	61,301	55,449
Freja, Inc. - Income Statement (in thousands)
	2016 unaudited	2015	2014
Net Sales	$ 118,000	$ 102,000	$ 85,000
Cost of Goods Sold	$ 86,140	$ 70,360	$ 56,950
Gross Profit	$ 31,860	$ 31,640	$ 28,050
Selling, general and
administrative expenses	$ 24,780	$ 19,380	$ 15,300
Research & Development	$ 3,540	$ 4,080	$ 4,250
Depreciation	$ 950	$ 800	$ 800
Patent Amortization	$ 500	$ 500	$ 500
total expenses	$ 29,770	$ 24,760	$ 20,850
Operating Income (Loss)	$ 2,090	$ 6,880	$ 7,200
Interest Expense	$ 2,600	$ 1,200	$ 1,100
Income (Loss) Before Income Taxes	$ (510)	$ 5,680	$ 6,100
Income Tax Expense		$ 1,988	$ 2,135
Net Income (Loss)	$ (510)	$ 3,692	$ 3,965